14 December 2010
A discounted cash flow (DCF) is the most fundamentally correct way of valuing an investment. Most other methods of valuation, such as valuation ratios, can, to a large extent, be seen as simplified approximations of a DCF. The many estimates and assumptions required by a DCF introduce a lot of uncertainty, often making it no better than simpler models.
The value of an asset is the value of the future benefits it brings. The value of an investment is that cash flows that it will generate for the investor: interest payments, dividends, repayments, returns of capital, etc.
These cash flows need to be adjusted for two things:
the time value of money the risk that the amount of money will not be what is expected. In a DCF valuation, a discount rate is chosen which reflects the risk (the higher the risk the higher the discount rate) and this is used to discount all forecast future cash flows to calculate a present value:
PV = (CF1)/(1+r) + (CF2)/((1+r)2) + (CF3)/((1+r)3) ⋅⋅⋅ where PV is the present value of the stream of cash flows CF1 is the cash flow the investor receives in the first year, CF2 the cash flow the investor receives in the second year etc. and r is the discount rate.
The formula above can be adjusted for periods other than a year in the same way as the NPV formula. The formulae differ because this excludes the time zero cash flow: e.g. the cost of buying a security.
In the case of bonds, the cash flows would be interest payments and repayments. Shares are more complex and give us a choice of methods. Hybrid securities may be bond like (and therefore can be valued using a DCF), or contain embedded options that need more complex valuation.
As mentioned in passing above, the actual cash flows shareholders receive, and therefore the obvious cash flows to discount are the dividends. This is also theoretically the most correct thing to do. The problem with discounting dividends is that not only do you have to forecast the performance of the company, you also need to guess its future dividend policy.
As the money made by a company belongs to its shareholders regardless of whether it is paid to them or not, we can avoid having to guess at dividend policies by instead discounting the company's earnings. So can we discount the EPS? We cannot, because retained earnings are invested and boost future earnings. Simply discounting future EPS would lead to double counting.
Profits do no necessarily bring in cash to the company (as profits are calculated using the accrual principle). Therefore it makes sense to discount cash flows instead. If we discount free cash flows we also get rid of the double counting problem. Financial theory would also suggest that unless a company has very high return opportunities for expansion (or is investing very badly) then the difference in valuation between a dividend discount valuation and a free cash flow discount valuation will be comparatively small.
Many discounted cash flow valuations do not explicitly include all cash flows a holder of a security may receive. This is discussed in greater detail with regard to the discount at which non-voting shares trade compared to ordinary shares.
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